Outlook for the Australian Dollar

This first article in a series of monthly looks at Asia-Pacific currencies concentrates on the Australian dollar. Its strength over the past month has been considerable, with gains ranging to 15% against the yen, a more sedate set of gains against the other major currencies of between 5-7%, with a notable fall against the New Zealand dollar of approximately 2%. The latter can be attributed the exceptional circumstances of natural disasters, but within that there lies a critical point to remember. The same story does not always mean the same price action. I refer specifically to the comments that were widely reported after the Japanese earthquake. Commentators quickly correlated this to the previous Kobe earthquake and predicted that the yen would strengthen significantly, by as much as the 20% that occurred in 1995. While the initial knee-jerk reaction was lower, the greater gravity of the recent disaster and wider economic impact in an increasingly globalised world meant that intervention to support the yen emerged. The importance of allowing price action to influence decision making rather than a fundamental mantra was amply demonstrated.

Returning to the Australian dollar, there are a variety of macro elements of the economy that have to be considered in understanding whether any long-term change in direction could unfold. These include:

The economy has been one of the strongest performers, but the attempts by China to control growth and inflation will impact Australia. An early warning sign is the relative weakness in base metal prices in the last few months, which is amplified when considering the weakness in the US dollar. Evidence of the use of physical copper as collateral to circumnavigate the lending controls instigated in China to reduce speculation in property, adds a further warning to what could happen to base metals if sentiment turns ugly.

The central bank has been cautious in its outlook, and this is reflected in interest rate expectations which only price in a 25 basis point rise by year end. This is in sharp contrast to some other developed blocs.

Some of this caution is possibly tied to the long standing issue of high personal debt, and a perception that house prices remain overvalued.

If any worries resurface about global debt, Australian banks would come into focus due to their heavy reliance on foreign funding.

The performance of the currency has been closely correlated to the rise in global stock markets. The importance of this is shown in Figure 1 by the sharp but brief fall that occurred mid-March.

Unwinding of the carry trade. The large interest differential between Australia and other major trading blocs is a long-standing positive but, again, history shows that when this unwinds, everyone heads for the exit at once and the falls are often dramatic. This is shown in Figure 2.

Figure 1: Correlation Between the Australian Dollar and Global Stock MarketsSource: CQG

Figure 2: The Unwinding of Carry Trade Prompts a Dramatic Fall

Source: CQG

While it is necessary to be aware of these issues, the current environment from a price prospective remains relatively benign, although that can change quickly, as you can see in Figures 1 and 2. Those who have Australian dollars enjoy a relatively high deposit rate in global terms, which provides some insulation against sudden falls. This is especially true against the US dollar (in spite of the short-term extreme negative sentiment reading). It is worth remembering that the technical picture shows that there is no resistance until 1.1500 to 1.1700, as we are at levels not seen since the major global currency adjustments from the late 1970s. It takes a weekly close below 1.0200 to signal any sign of a warning and a period below 0.9170 to suggest a more long-term structural change in trend.

Looking ahead at the calendar for Australia, 11 May is of particular focus as there is the combination of the budget statement, and a series of statistics from China including industrial output, retail sales and both the Producer Price Index (PPI) and Consumer Price Index (CPI). Preceding that, on 6 May, is the quarterly statement on monetary policy.

There has been an uptick of treasurers inquiring about interest rate risk management in recent months as interest rates in the US and UK have started to show a rise in momentum, said Chatham Financial at the annual Bellin treasury conference.